Does free trade bring lower prices?

by on April 29, 2007 at 7:43 am in Economics | Permalink

Dani Rodrik says not really:

Advocates of globalization love to argue
that free trade lowers prices, and the argument seems sensible enough.
Think of all the cheap goods from China that we can buy at Wal-Mart.  But anyone who understands comparative advantage knows that free trade affects relative prices, not the price level (the latter being the province of macro and monetary factors).  When
a country opens up to trade (or liberalizes its trade), it is the
relative price of imports that comes down; by necessity, the relative
prices of its exports must go up!  Consumers are
better off to the extent that their consumption basket is weighted
towards importables, but we cannot always rely on this to be the case.

The intuition is this: if my household suddenly trades with the outside world, bread is cheaper but my wife has superior opportunities than before.  It might be harder for me to bid for her time and I will have no one to play tennis with.  If I enjoy tennis enough, I might be worse off.  If you want a real world example, American
ethanol use is bidding up the price of Mexican corn; not every
campesino is better off.

Greg Mankiw responds, and Rodrik in turn, then Mankiw again.  I would put it as such.  The real gain from trade is the additional output; it should not be surprising if the pecuniary externalities (higher and lower prices) should prove a wash rather than an additional net gain.  In fact a wash of the pecuniary externalities helps ensure that the output effect dominates the welfare calculus. 

More empirically, having your export prices bid up is a wonderful driver of growth more than it is a distributional or efficiency nightmare.  The net externalities of that process are usually positive rather than negative, even without firm- or industry-level increasing returns in the traditional sense.  The exports help build a middle class and in the long run make democracy and rule of law possible.  The dynamic effects are the key to the benefits of trade, and neither the Ricardian nor the Heckscher-Ohlin model is satisfactory.  The best simple (ha!) model has trade bringing more innovation, new goods with high consumer surplus, greater reason to work hard and get ahead, greater domestic inequality, a growing middle class, and new and usually more liberal political coalitions.

Empirically, the troubled cases of trade typically involve exports of oil or diamonds and subsequent corruption.  The relevant problem with trade is not higher prices for home consumption, in fact home consumption of those commodities is usually quite low.  How much oil does Guinea-Bisseau use?  We’re left with Mexico and corn prices as a possible example, but note that Mexico would have much lower corn prices with free trade in corn.  And it is U.S. government subsidy, not the market, bidding up the price of corn in the first place.

Maybe we’re left with this as the relevant real world example: outsourcing in India drives up wages and makes life harder for people who want lots of servants.

My Inner Misesian is uncomfortable with Rodrik’s strong distinction between relative prices and the absolute price level.  Productivity shocks (which are in critical regards analogous to an expansion of trade) can and do lower most of the prices we face, albeit not all of them.

I don’t disagree with Rodrik’s claims about positive economics, although they don’t quite "shade" as I might wish.  I would have liked to have seen the sentence: "The early 20th century trade theorists discussed by Jacob Viner and Gottfried Haberler knew about these problems, but they also realized they did not, when viewed in a realistic context, weaken the case for free trade."

Addendum: Read this survey paper on trade.

John Mark van Rozendaal April 29, 2007 at 8:47 am

Where is free trade happening? It seems to me that wherever people are using government-issued currency and government-regulated banking they are in a highly regulated market, not a “free” one. So remind me, where does all of this “free trade” happen?

Steve Miller April 29, 2007 at 9:46 am

I think it’s pretty clear that for the median American shopper, the trend of big-box stores sell large amounts of imported goods has led to lower prices. And those prices are lower, not only for imported goods, but for domestically-produced groceries as well. Whether that’s the result of “free” trade or not is debatable, but it’s clearly a result of more trade around the world. For those who like to criticize conventional economic models, take a close look at the standard monopoly model, that predicts lower output and higher prices with more monopoly power. But with Wal-Mart and other big-box stores we see more output at lower prices. Wal-Mart’s monopsony power, for example, may explain lower-than-predicted prices but not greater output.

http://econ-www.mit.edu/faculty/download_pdf.php?id=1243

Russ Nelson April 29, 2007 at 9:51 am

Rozendaal: we can compare more free trade to less free trade. Of course thieves will always need to be a part of this analysis, even the ones we elect.

Keith April 29, 2007 at 11:03 am

Well, Rustbelt, outsourcing is essentially freer trade in more highly skilled labor, so the benefits of outsourcing actually flow downward. So that free trade pie is bigger, and the distribution is skewed towards those poor unemployed rustbelters.

Therefore, if you care about equality, you must love outsourcing (although you could still oppose free trade in textiles).

economister April 29, 2007 at 11:26 am

Tyler, what about Dani’s example? Beef is to Argentina and Uruguay what corn is to Mexico and Central America. There has been some real tension in Argentina, where the government has “negotiated” “self-imposed” internal price controls. Doesen’t this count as a relevant world example?

Tyler Cowen April 29, 2007 at 12:01 pm

Make some poor people wealthier, and inequality goes up while the number of people in the middle class goes up. The real world story is more complicated than that, but at the very least the two mechanisms are compatible.

michael vassar April 29, 2007 at 2:40 pm

Consumers only loose if supply is relatively inelastic/if there are diseconomies to further increases in scale. When there are economies to scale consumers and producers gain, as increased demand increases the scale of production raising the quality and lowering the cost of production. Silicon chip manufacture, for instance, would be difficult for a local market.

ricpic April 29, 2007 at 3:01 pm

josh stole my thunder. Doesn’t increased output – more goods chasing the same number of consumer dollars – result in lower prices?

Anton Tykhyy April 29, 2007 at 3:59 pm

U.S. ethanol subsidy surely bids corn prices up, but first the farm subsidies bid them down! Where’s the logic?

Mike April 30, 2007 at 10:14 am

Re: ethanol and corn prices …

… isn’t the market for corn supposed to be as close to perfectly competitive as economists see? Why, then, should we not expect long-run corn prices to fall back down? As agricultural productivity has improved, I just don’t see that long run corn cost curves have that steep a slope over reasonable ranges of corn production. Shouldn’t the ethanol boom really be a real estate boom for certain places? And the LR impact on corn prices minimal?

Nathan Zook May 3, 2007 at 1:15 pm

Spencer,

He might not, but I will. There is a poverty floor. People without enough money to puchase food and shelter die–usually sooner rather than later. This floor acts as a great equalizer-through-attrition in an impoverished area. The only comparable ceiling is theft.

Look at industrialization. The “robber barons” of the day held wealth unimaginable by the true robber barons, both in absolute and relative terms. Average wealth grew tremendously, and the people who were most directly responsible were appropriately compensated.

Suppose I live in a commune with nine other people. Suppose I figure out how to add twenty dollars of wealth to the commune. Being a good communist, I give half to the commune. I end up with eleven dollars, everyone else one. All are better off. The average is up. Inequality is way up.

Deal.

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